TIPS Could Get Hotter if Bonds Head South

PLAIN-VANILLA TREASURIES, which have been the bond market's favorite flavor the past couple of years, could lose that spot to their slightly more exotic variant, TIPS, or Treasury Inflation-Protected Securities. While the conventional wisdom holds that inflation fears are premature because government indexes show consumer and producer prices have yet to turn up, many bond-fund managers aren't waiting on such a possibility.

"As soon as an economic recovery takes hold, all the pieces for a major inflation fear and bad bond market will be in place," posits James Paulsen, chief investment strategist of Wells Capital Management.

Paulsen lists a litany of negatives facing the bond market: The Federal Reserve overdoing monetary easing, taking the federal-funds rate target of 1&frac14;% to four-decade lows; the burgeoning budget deficit; the dollar softening; the year-long surge in commodity prices, highlighted by strong gains in oil and gold; the real yield on long-term bonds hitting less than 1.5%, far below the 3% to 3.5% "normal" margin over inflation in recent years; and the surge in gold and oil prices.

"There is enough to create inflation fear more than actual inflation," says Paulsen, who in years past was a prescient and cogent member of the disinflation camp. But those inflation fears will be enough to spook the bond market.

Having said that, there are money managers who already have played defense.

Marc Seidner, director of domestic taxable fixed-income at Standish Mellon Asset Management, says, "Inflation expectations are definitely increasing," and he can tell by looking at the collapse in the yield on TIPS.

As with a traditional bond, the semiannual coupon rate on a TIPS issue is set. The yield on TIPS is "real" -- that is, what's left after inflation. The TIPS' principal is adjusted annually to reflect inflation's erosion of its real value. (The bigger the rise in the consumer price index, the bigger the increase in TIPS' principal.)

Seidner points out that the difference between the yield on the 3% T-note due November 2007 at 2.76% and that of the comparable 3 5/8% TIP due January 2008 at 1.05% is 1.71%. The latter number represents the market's implicit inflation forecast.

On Dec. 31, the yield on the nominal 3% Treasury was at 2.73%, while TIPS were priced to yield at 1.62%. That spread meant the market was discounting inflation of just 1.11%.

Clearly, inflation expectations have ratcheted up already in 2003, notes Seidner, and "there is still room for TIPS to outperform Treasuries." While the break-even rate has risen to 1.71%, it is still well below the actual year-over-year change in the Consumer Price Index of 2.6%, he adds.

"So if you take current inflation rate and add to it the real yield of 1.05%, you get 3.65%, which is still [0.89 percentage points] higher than the nominal yield of the Treasury bond," says Seidner, who has been holding intermediate-maturing TIPS over the last 12 months.

Still, Treasuries gained in price on the week, with the yield on the two-year note ending Friday at 1.59%, down from 1.69% a week ago.

The benchmark 10-year note yield, meanwhile, closed the week at 3.89%, down from 3.99% the previous Friday. The yield on the 30-year Treasury bond settled Friday at 4.85%, down slightly from 4.88% the preceding week.

Convertible drivers

How hungry are investors in convertible bonds for new paper these days? Enough to skip breakfast to get in on a hot deal.

Affiliated Managers Group,
an asset-management holding company based in Prides Crossing, Mass., marketed -- and sold -- a $250 million convertible-bond offering before the stock market opened on Wednesday. The deal was announced at 7:30 a.m. that day and was completed before 9:30 a.m.

(Convertibles are hybrid securities, either bonds or preferred stock, that can be exchanged for a predetermined number of common shares. That effectively lets an investor participate in the equity's action, but with the greater yield and safety of a fixed-income security.)

Indeed, Affiliated Managers has sold convertible debt several times before, so investors already were familiar with the name. That helped facilitate Wednesday's transaction.

It isn't uncommon for the convert market to see "overnight deals" -- offerings announced and marketed the night before it is scheduled to be priced and sold.

But the offering by Affiliated Mangers, underwritten by Merrill Lynch, is the latest illustration of how the convertible market is able to digest new deals even if just in a matter of hours.

Who is in the driver's seat for these convertibles? As usual, hedge funds, which are active users of a strategy known as convertible arbitrage.

"Strong convertible-arbitrage performance in recent years -- both absolute and relative -- has led to huge fund inflows to the strategy," explains Scott Lange, head of U.S. convertible research at Goldman Sachs. "This has given the arbs a substantial amount of excess buying power. Combine the arbs with crossover equity buyers with very deep pockets, and you end up with a convertible market with an unprecedented ability to take down new deals."

In their most basic form, these strategies involve purchasing the convertible and simultaneously selling short the underlying common stock. That captures the fixed-income portion while hedging the equity risk.

Hedge funds use far more arcane tacks that effectively separate the bond and stock portions, attempting to wring out greater value from the sum of the parts. Hedge funds have been attracted to convertible bonds to capture the volatility in the equity warrant embedded in these securities. And, of course, the funds try to magnify these returns with leverage.

What the hedge funds need are new issues to play with. With more money chasing this strategy, 24 out of the last 30 convertible deals either have increased in size or were priced in the issuer's favor, in terms of conversion premium, or coupon, or both, according to calculations by Goldman.

Affiliated Managers' converts due 2033 will yield one-half percentage point under the three-month London Interbank Offered Rate (currently 1.34%), paid quarterly. The issue can't be called for five years and was priced at a hefty premium of 77.79% over Affiliated Managers' Tuesday closing stock price of 45.70.

"There is demand in the convertibles market for $50 billion plus of paper that would get taken down very easily," quipped Larry Bucher, managing director of convertible sales at KBC Financial Products, a brokerage firm based in New York.

Last year, hedge funds that use convert-arbitrage strategies turned in a total return of nearly 10%, according to the Goldman Sachs U.S. Convertible Arbitrage Index. The previous year, it was almost double that. By comparison, the Lipper Convertible Securities Funds Index posted a total return of negative 9.3% last year and negative 4.7% the previous year.

But with hedge funds flush with cash and limited opportunities to deploy the cash, Goldman Sachs estimates that the average fund leverage is at about two times.

In recent years, the hedge funds employed in convertible arbitrage typically were leveraged four to six times. During the bubble days, specifically March 2000, leverage would be 10 times.

"But the convertible market is better credit-hedged than ever before through shorting straight debt, asset swaps and credit-default swaps," points out Bucher of KBC. "On a risk-adjusted basis, they are taking less risk than they were four to five years ago."

Moreover, "it provides solid evidence of the excess buying power available in the market, and the strong technical support that we believe will remain the key force in shaping valuations over the near term," concludes Lange.

TIPS Could Get Hotter if Bonds Head South

PLAIN-VANILLA TREASURIES, which have been the bond market's favorite flavor the past couple of years, could lose that spot to their slightly more exotic variant, TIPS, or Treasury Inflation-Protected Securities.

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